Mounting market uncertainty has triggered substantial corporate interest in managing translation and transactional risks as foreign exchange (FX) volatility continues to batter the balance sheet of companies.
In the FX space, there have been sharp losses in higher-beta G10 and emerging market currencies, notably those of commodity-exporting countries in the past few months. This was prompted by rising uncertainty around the Federal Reserve’s (Fed) move to start tapering quantitative easing (QE) in the next few months, highlight experts.
For example, the Indonesian rupiah fell for a record 11th day on July 19 and weakened beyond the IDR10,000 per dollar level to 10,078 for the first time since 2009.
As a result, corporates – even the conservative ones – have become more interested in embarking on strategic hedging in order to mitigate translation risk brought about by growing currency volatility, especially in the emerging markets.
“As US yields moved higher, volatility picked up on the expectation of Fed tapering later this year and the elimination of QE next year,” said Callum Henderson, global head of FX research at Standard Chartered to Asiamoney PLUS on July 25. “From a corporate perspective, this volatility has triggered a wave of interest in longer-term, strategic hedging of transaction risk rather than maintaining a shorter-term approach.”
Source: Standard Chartered
Translation exposure results from when the assets and liabilities of a subsidiary are converted back into the parent currency. In practice, large fluctuations between the subsidiary and parent currencies can have an important impact on the consolidated balance sheet.
“The impact of sharp FX swings between the subsidiary and parent currencies on the consolidated parent balance sheet has also led to much greater focus by Asian treasurers on managing translation or balance-sheet risk across the region,” said Henderson. “This is particularly important for US corporates at the moment in the context of the strong US dollar up-trend with the slide in local currencies impacting the consolidated balance sheet at year-end.”
Beside US-based companies, Chinese corporates – which are still relatively new to the idea of hedging –have even resorted to using forward contracts available to them both in the offshore and onshore markets.
“The concept of hedging is still relatively nascent in the Chinese corporate world,” said Oliver Brinkmann, head of capital markets and treasury solutions for Greater China at Deutsche Bank. “However, many of the corporates that we see today are increasingly making use of hedging strategies.”
“Some of them tend to go in the three to six months range just to see where the markets are going,” he added. “However, if you know your sales volume and your cost base, it might be a wise decision to lock in the fx rate for a longer period so that you have greater certainty in your P&L.”
Translation versus transaction risk
From a translational risk perspective, the hedging practices embarked by corporates tend to be more long-term and strategic.
Treasurers often hedge their projected cash flows denominated in foreign currency for the entire financial year in order to minimise the impact of fluctuations on their future balance sheet, note experts. That way, the profits that are realised 12 months later are covered.
However, this is not the same for transactional risk, which is the exchange rate risk associated with the time delay between entering into a contract and settling it. The greater the time differential between the entrance and settlement of the contract, the greater the transaction risk because there is more time for the two exchange rates to fluctuate.
These tend to be working capital-related transactions, where the duration of the hedges put in place are no longer than 90 days, with the average of around one month, note bankers.
Nonetheless, there are pros and cons of hedging for the short term.
“The advantage of short-term hedges is that corporations can adjust their positions accordingly, as these short term hedges are meant for working capital or transactional type of related FX risk management,” said Andrew Ong, head of liquidity and investments at Bank of America-Merrill Lynch (BoA-Merrill).
“[With emerging market currencies weakening], corporations need to realise that every time a short-term hedge matures, there will be a potential unrealised loss that they will have to realise at maturity,” he added. “This may have significant impact on the working capital.”
For example, if the Indonesian rupiah continued to depreciate against the dollar, a corporate with rupiah borrowing requirements would need to shore up extra local currency in order to extend the hedge. This eats into the company’s funding.
There are, however, methods to refilling the shortage the currency, especially as it continues to depreciate. One way is via the usage of a corporate’s multi-currency notional pooling structure.
The primary target of each cash pool is the optimisation and use of surplus funds of all subsidiaries in a group in order to reduce external debt and increase liquidity.
“Multi-currency notional pooling is used to smooth out and help our clients manage their working capital cycles,” said Ong. “If they are short of the local currency they can actually utilise the surplus US dollar without actually selling the dollars to fund their local currency requirements.”
This is much cheaper than having to ask bankers to offer a temporary overdraft line or obtaining a bank loan for liquidity shortages beyond the duration of two to three quarters, note experts.
However, regardless of whether it is translation or transactional risk, corporates should smartly seize the opportunity to hedge these exposures during less volatile periods.
“In the last two weeks, we have seen a significant pullback in volatility. In our view, corporates should use this pullback as an opportunity to add to more strategic hedges, whether against longer-term transaction risk or balance-sheet risk,” said Henderson. “Options offer greater flexibility for that purpose, allowing for hedging policy and accounting requirements.”